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The High Cost of Making High Cost Payday Loans

Adam Rust's picture

Posted February 5, 2013

The unfortunate - at least for their practitioners or for their investors - part about making high cost short-term payday loans is that it is ultimately not very profitable.

Most people probably imagine that you could earn more profit by charging

someone $56.71 to borrow $377.34 for two weeks than you might by selling a double cheeseburger for one dollar. Most people would be wrong, though: high-cost lending is less profitable than selling hamburgers.

Let's compare QC Holdings (QCCO), an almost pure-play payday lender, with McDonalds (MCD). Since these firms have very different capital structures, it is probably best to just compare them on as close to the transaction as possible. Operating margin - the amount of profit that a company can make after expenses from operations - is one solution. On that count, hamburgers eat payday for lunch. The operating margin at QCCO is 10.89 percent. The operating margin at McDonalds, on the other hand, is 30.3 percent.

The business model behind payday lending is flawed.

If you want to stick to within financial services, then boring banking can be a lot more profitable. One of my favorite boring banks is Commerce Bancshares (Kansas City, Missouri). Right now, they are generating a margin of 40.12 percent on a mix of basic old-school banking businesses. Moreover, they aren't the only successful boring guys. Check out Cullen Frost - very boring at 36.7 percent. Bancorp South rates high on the boring scale. They pulled in a margin of 20.1 percent last year.

To be fair, though, those banks can access capital for virtually nothing and that makes a big difference on margins. In our version of a free market, banks exchange the burden of regulation for several benefits, not the least of which is that they can draw funds from the discount window.

There are two big costs associated with lending at high cost: first, it costs a lot of money to find customers, and second, lots of people never pay back their loans.

Getting a new customer is almost pyhrric in nature, because they seem to represent all that is problematic about the business from the perspective of an owner. Payday lenders need new customers because too many of their existing customers go bankrupt. Unfortunately, once new customers are in the door, they are much less profitable, because they are so much more likely to never pay back their loans.

Don't take it from me, though:

Cash America says, "New customers tend to have a higher risk of default than customers with a history of successfully repaying loans."

Dollar Financial: "Loans made to newer customers tend to carry higher loss rates until our level of experience (i.e., knowledge of customer behavior) with the customer increases."

Given that sometimes there were cases when old borrowers took out a second loan, only 15.4 percent of consumer loans were given to borrowers that were entirely new to the company. For fiscal 2012, 2011, and 2010, refinances made up 75.9%, 75.9% and 76.4%, respectively, of consumer loans at World Acceptance.

Given that those new customers produce so many problems for repayment, the fact that many payday lenders are still eager to find them speaks to an inherent vulnerability. JMP Securities recently estimated that online payday lenders end up paying between $100 and $300 for every purchased  "high-quality lead." What is a 'high-quality lead?" It is simply one that actually results in a loan. According to JMP, only about 40 percent of mid-to-high quality leads convert into borrowers.

If each loan is only generating $57 in fees, then it takes two loans just to pay off the lead generation bill. According to JMP, if a lender could drive down lead generation costs by 10 percent, then profitability could go up by at least 20 percent.

Secondly, it is a business which accepts the high likelihood that many loans are going to sour. In a typical payday scenario, a borrower rolls over a loan several times. On any loan, the chance of a default is usually about 3 percent. All too often, though, the borrower defaults in the end, albeit on their 8th go around. Thus, payday's model has to generate enough fees to compensate for the loss of principal on a fairly high share of credit extensions.

Those numbers mask a dark side. When so many loans go bad, it means that a fair number of people have fallen so far on the wrong side of zero that they just give up.